Loan Pricing- Setting Interest Rates
Mortgage rates are an essential part of the home loan process. Since the majority of home owners do not have enough cash on hand to pay for a home in full, the only other available option is to secure a mortgage from a lending institution. While this is a normal, everyday process, lenders still expose themselves to a certain amount of risk with every mortgage they extend. Therefore, the focus of a mortgage from a lender’s perspective is the amount of return a mortgage will produce for the amount of risk assumed. To help assess risk and set rates to make money, lenders use risk-based and other types of models to assist with loan pricing.
How Is Loan Pricing Set?
Some homebuyers are less risky than others and have built relationships with lenders over time. Although these are more trustworthy borrowers, lenders must still account for the possibility of default. However, these typically receive loans with better rates. Those with a higher risk will get less than desirable rates. This information is attained by the lender’s use of risk-based models such as credit scores and reports.
Beyond an individual’s credit, lenders also have to consider the general state of the economy. The Federal Reserve, inflation, and secondary mortgage markets are other key components in determining rates. A secondary mortgage market is where lenders make a loan, then turn around and sell those loans to larger, third-party investors.
Although these determining factors can be extremely complex, risk-based pricing helps determine rates and other fees that allow lenders to be compensated for the risks they take.
What Does Risk-Based Pricing Mean to Homebuyers?
For most homebuyers, ignorance is bliss. Outside of market value, the main concern is securing the lowest rate possible. There’s generally no interest in understanding how the rates are set. However, even a basic knowledge of rate origination and pricing can assist in the home buying process, as even a single digit difference in the rate can means tens of thousands of dollars either way. Just as lenders can offer the best rates to optimize their capital,
homebuyers should shop for the best rates that make the most financial sense and ask detailed questions of their lender on how their rate will be set.